not able to understand delta in options. Whilst I understand, it is how much the option moves when the underlying moves by 1 unit, I fail to understand, when someone books a currency option, why does the delta need to be hedged.

$\begingroup$If I open a position in currency options I wouldn’t and don‘t need to hedge the delta. However ever I could use it for delta hedging my currency exposure. Maybe this is mixed up by @Shyam.$\endgroup$
– FokkoMar 23 '19 at 13:14

$\begingroup$Slightly confused with that answer - one would hedge as much (or not) as with an option on any other underlying...$\endgroup$
– ZRHMar 23 '19 at 13:25

3 Answers
3

It is true that when FX options are traded, the delta is often traded as well. That is a practice specific to the FX option market. It is called an "exchange of delta". You can undo it by selling the delta in the spot market immediately after the option trade. Or you can request no delta exchange at the time you make the trade.

$\begingroup$The "package" of the option plus the spot delta is easier to price. Price depends only on vol, not on vol and spot price of currency (at least no first order dependency on spot price). The "package" is also very convenient for those market participants who delta hedge in any case. As mentioned, those who do not wish to delta hedge can get rid of the spot delta in a separate transaction.$\endgroup$
– Alex CMar 23 '19 at 14:59

1

$\begingroup$Another case, where delta is exchanged, are some niche markets, where trading is not done electronically, but negotiated via phone. by pre-agreeing the underlying price, the need to reprice the deal during negotiation every time the underlying price moves, is eliminated. as mentioned by AlexC, if you wish to use options for obtaining an outright position, you can turn around and trade out of the delta hedge.$\endgroup$
– ZRHMar 23 '19 at 15:31

$\begingroup$This is not specific to the fx options market, it is standard in equity and commodity markets too - when not trading on screen. The reason is that if you want to trade delta you do it with futures. If you want to trade vol you do it with options, including the delta in the trade removes an additional delta you need to hedge after. Ie it is because options are used to hedge vol. We don't want the delta, that we'll do with futures. It also means that for small price moves quotes can hold for longer.$\endgroup$
– willMar 23 '19 at 20:24

$\begingroup$@AlexC so is there any significance of delta exchange while closing options. If I already have an import UL,there is no need to hedge delta right? typically delta hedging is done by traders?$\endgroup$
– ShyamMar 26 '19 at 1:15

When you buy or sell an option you can choose what type of exposure you would like to have. In layman's terms, if you leave the Delta unhedged you are exposed to the price movements of the underlying. You would want that if you care about the direction of the underlying and have a view on whether prices go up or down based on whatever research you would have done to back up your claim.

In another case maybe you would like to have exposure only to the volatility of the underlying and you don't want any directional movements of the underlying to affect your option. Then you would hedge your Delta in the Market, to be Delta-Neutral, so directional exposure would be zero, then you would be only exposed to the other Greeks such as for example Vega, which is 1st order Greek, and stands for the volatility of the option. You would be speculating on certain events maybe that would cause prices to widely fluctuate without any particular direction. When you trade options you usually ask yourself, what is the price expectation of the underlying, what do I want to have exposure to in particular, which hedging options exist and how is the market positioned, what is the market mispricing. This is the most basic approach usually. If you believe the market should price the underlying higher or lower, you keep your delta exposure on the book. If you believe the price will fluctuate heavily you delta hedge and have a pure volatility play on your book because you believe that IV, Implied Volatility, is mispriced and the market is wrongly positioned based on the option smile for example. I tried to keep this explanation as basic as possible to ensure easy understanding. Hope it helps. The FX market has plenty of institutional participants such as Market Makers. Market Makers (MM), in general, do not care about directional movements in the underlying FX pair as their job is to price two-way prices, profiting from the bid/ask spread. Generally, MM's can keep the volatility exposure as that doesn't fall under the speculation regulation of directional positioning in the market, hence market makers, depending on the positioning of their book can profit from pure vega exposure, on the simple level of explanation. There is more than just vega regarding volatility, there is Vanna or Volga, but I leave it at just vega for the purpose of answering this question.

Delta does not have to be hedged. If you want to use options to make a directional bet, you don't want a delta hedge.

However, you don't need options to make a directional bet, that's what linear positions are for. What you can do with an option that you cant so with an outright position or linear derivative, is get an exposure to volatility.

Now if you have a position in an option, you have exposure to both volatility and directional changes. To take out the directional exposure, people delta hedge. A bit more precisely, when delta hedging, your profit or loss will depend on the difference between the implied volatility you bought or sold the option for and the realized volatility of the underlying. That PnL will realize through the option payoff, PnL on the delta hedge and interest on the cash

$\begingroup$what you say is correct for those who genuinely trade volatility (typically option market makers). However, there are hedge funds who use options to express directional views. Technical things aside (ie simultaneous exposure to underlying and vol), there is a number of reasons to do so: i) max downside is equal to premium paid, ii) you trade OTC and have poor credit lines, iii) you do not want to be exposed to margin calls (note this depends on whether options are futures-style or equity-style)$\endgroup$
– ZRHMar 23 '19 at 15:37

$\begingroup$Lets say, I need to hedge 1mio EURUSD using Buy Call. Current level of 1.1320 and my buy call is at 1.1400. When i try to execute the trade, using black scholes, lets say N(d1) is 70%, so my delta exchg will be 700k EUR at 1.1320(prevailing spot). Now if i dont hedge delta, or just sell 700k EURUSD, does it impact my and/or counterparty P&L ? I tried to google a lot on hedging delta, and why its done. Can't find much, Would you'll have any resources?$\endgroup$
– ShyamMar 23 '19 at 15:47

$\begingroup$@ZRH, not disagreeing with you, I just think the question is coming from a bit more basic point of view and OP is trying to understand basic option theory$\endgroup$
– BramMar 23 '19 at 19:31